Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation. Jeffrey Friedman and Wladimir Kraus. University of Pennsylvania Press, 2011, pp.212, $45.00 The majority of individuals involved in the Occupy Wall Street (OWS) movement tend to blame Wall Street bankers for the financial crisis and the ensuing recession and high unemployment rates. By contrast, [...]
Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation. Jeffrey Friedman and Wladimir Kraus. University of Pennsylvania Press, 2011, pp.212, $45.00
The majority of individuals involved in the Occupy Wall Street (OWS) movement tend to blame Wall Street bankers for the financial crisis and the ensuing recession and high unemployment rates. By contrast, many in the Tea Party movement have appeared to focus their ire more on the federal government’s response to the crisis than on the root causes of the crisis itself.
Both movements, however, seem implicitly to agree that those economic and political actors most involved in the crisis and its aftermath were consciously motivated by either greed on the one side, or by a desire to grow government at the expense of liberty on the other. One would have to search very diligently to locate a protestor, either of the OWS or of Tea Party variety, who would say that the financial crisis was caused by ignorance, rather than by hubristic bankers or by the federal government’s willingness to bail out too big to fail financial institutions.
By contrast, in Engineering the Financial Crisis, Jeffrey Friedman (University of Texas, Austin and editor of Critical Review) and Wladimir Kraus (Université Paul Cézanne Aix-Marseille and associate editor of Critical Review) posit that, “the crisis was caused by ignorance on all sides.” While this specific line of argument is nuanced and certainly more philosophical than most analyses of the financial crisis, the authors do seem to suggest that there was no single deliberate, conscious decision, nor set of decisions by a capitalist or by an individual regulator that precipitated the financial crisis.
Indeed, a reader looking for either an excoriation of greedy bankers or a diatribe against close ties between Washington and Wall Street will surely be disappointed by the authors’ provocative academic monograph. Private label mortgage backed securities (PLMBS), however, do play a prominent role in the authors’ understanding of the crisis. The authors’ focus, however, is less on the securities themselves than on addressing why so many financial institutions purchased them.
In the book’s introduction, they emphasize that, in their opinion, there is no evidence that Fannie Mae and Freddie Mac’s lending practices, banks’ perception of their alleged too big to fail status, bank compensation practices, or “irrational exuberance” caused the financial crisis. A refrain in Friedman and Kraus’s work is that the too big to fail theory does not hold up under scrutiny. There is indeed considerable merit to their argument, particularly given the fact that they provide data to back up their claim. Readers will have to decide for themselves, however, whether the authors protest too much against the admittedly highly popularized too big to fail narrative. Often conventional wisdom is wrong; sometimes, it persists for a reason and does contain more than a kernel of truth.
If the traditional and oft-repeated narratives, in their view, do not satisfactorily explain what caused the latest crisis in global capitalism, then what does? The authors suggest that the crisis was not caused so much by capitalism, as by capitalism’s regulators. This goes to the heart of the authors’ essential argument that “the crisis was a regulatory failure in which the prime culprit was none of the usually targeted factors, but was, instead, the set of regulations governing banks’ capital levels known as the Basel rules.” Specifically, they single out the Recourse Rule, an American “regulation governing capital requirements for asset securitization and sale by U.S. banks,” which was finalized in 2001. In technical terms, the Recourse Rule amended Basel I to give AA- and AAA-rated PLMBS the same risk that the Basel Accord officially gave to agency bonds.
The Recourse Rule, the authors suggest, explains why so many banks loaded up on private label mortgage backed securities. Capital adequacy regulatory policy incentivized banks to buy PLMBS. “Without the favorable treatment of highly rated PLMBS by the Recourse Rule, U.S. commercial banks might have acquired only a third of the exposure to PLMBS that they did, in fact, acquire.” Regulatory policy also had a homogenizing effect on banks. As Friedman wrote succinctly in a thoughtful op-ed for the Wall Street Journal in 2009: “Regulations homogenize. The Basel rules imposed on the whole banking system a single idea about what makes for prudent banking. Even when regulations take the form of inducements rather than prohibitions, they skew the risk/reward calculations of all capitalists subject to them.” Capitalism promotes heterogeneity; regulation, homogeneity.
The interaction of the Recourse Rule with both mark-to-market accounting, and what the authors contend was the quasi-oligopolistic status of the three credit ratings agencies, created the perfect storm, culminating in the financial crisis of 2008. Their conclusions have implications beyond the scope of the recent financial crisis. “The disadvantage of modern democracy,” write Friedman and Kraus, “is that in attempting to solve social and economic problems, either the people or their agents—legislators or regulators—must adopt a single interpretation that, in legal form, homogenizes behavior throughout the entire system. If this single interpretation is erroneous, the entire system may be jeopardized. That, we believe, is the chief explanation of both the financial crisis and the Great Recession.” Bold words indeed.
Although the authors mention that one of them will be interviewing some bankers as to whether the Recourse Rule did incentivize them to invest in PLMBS, the lack of bankers’ voices throughout the text is a notable weakness. That is not to say that those journalistic accounts of the crisis that detail the ‘who, what, and where,’ of the crisis are necessarily adequate explanations. Still, one would have preferred to see at least a few quotes from bankers, even if from unattributed sources who spoke in confidence, validating the authors’ thesis regarding the Recourse Rule. Furthermore, even if one fully accepts the authors’ arguments, this still leaves open the counterfactual question of whether the crisis would not have occurred but for the fact that the federal government promoted homeownership, cheap money was widely available due to extraordinary low interest rates, and the derivatives market was largely unregulated. While they do discuss these factors in the book’s first chapter, their analysis is far too brief.
The authors, at one point, appear to mistakenly conflate the concept of moral hazard with the principal-agent problem, both of which are particularly relevant to insurance regulation. Friedman and Kraus describe the theory that corporate compensation practices led to the crisis in terms of moral hazard. Of the “corporate-compensation thesis,” they write that, “bankers were put in a hazardous moral position, in which they might act contrary to the interests of their employers and society at large, by the incentives created by their performance bonuses.” Being put in a hazardous moral position is not moral hazard, properly understood. Indeed, corporate compensation is best understood as a principal-agent problem, wherein the interests of principals and their agents may diverge, thus leading bankers to engage in trades that are not in the long-term interest of their clients.
Finally, it should be noted that narratives of regulatory failures are far more compelling than regulatory successes; one does not ordinarily think of regulation when it actually works well, out of sight to most observers. It is when regulation fails (or is perceived to be failing), and particularly when it fails miserably, that elected officials and the general public become cognizant of the role of regulators and their regulations in attempting to manage complex, post-industrial societies.
In conclusion, despite some of the aforementioned criticisms, Engineering the Financial Crisis presents a compelling and novel argument as to what led to the near meltdown of both the financial sector and the real economy in 2008. The authors write clearly, present ample evidence to support their claims, and are extremely knowledgeable about financial regulation and political economy. While the book will not be accessible to the general reader, those readers with a specialization in economics, finance, or law will find it extremely valuable and worth consideration.
Jon Lewis (c) 2011